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The Beginner's Guide to Debt-to-Income Ratio

By Laura Agadoni · Apr 10, 2016 · Mortgage

The Beginner's Guide to Debt-to-Income Ratio

Image courtesy of BeSmartee, The Beginner's Guide To Debt-To-Income Ratio

Learn everything there is to know about debt-to-income ratio.

Before you buy a house, your lender will consider more than how much money you make. They'll look at how much money you owe as well. What you owe compared with how much you make is what lenders call your debt-to-income (DTI) ratio.

Lenders have DTI down to a science. So before you get too far into planning just where you'll plant your herb garden or where your TV will go, learn how to determine whether you'll qualify for a loan.

Bonus tip: Even if a lender says that you qualify for a mortgage, you need to make sure that you really can afford all the costs involved with homeownership. Besides the mortgage payments (the principal), you'll need to pay interest, taxes, and insurance. And there's an acronym for principal, interest, taxes, and insurance: PITI, which is pronounced, "pity." Take what you want from that! You'll also need to have some money set aside to maintain the house and to fix stuff that breaks.

How to Calculate Your DTI Ratio

Before you calculate your DTI ratio, here's a number to keep in mind: 43%. Why? That's the highest your DTI ratio can be for you to get most mortgage loans. The lower your DTI ratio the better.

Write down the following to determine your DTI ratio:

  1. Gross household monthly income
  2. Any other monthly income (investments, bonuses, side business)
  3. Rent or mortgage payment
  4. A second mortgage payment
  5. Car loan payment
  6. Student loan payment
  7. Any other loan payments
  8. Total minimum credit card payments
  9. Any other monthly payments

Now do this:

  1. Total your monthly income.
  2. Total your monthly payments.
  3. Divide your debt figure by your income.

Here's an example: if your total debt were $2,500, and your total income were $7,000, your DTI ratio would be 36% (2,500 divided by 7,000 equals 36%).

If you find that your DTI ratio is higher than 43%, you need to figure out a way to make more money, lower your debt load, or both. But there are sometimes other circumstances that lenders consider, even if your DTI ratio is high.

The video above will walk you through how to calculate your debt-to-income ratio using the BeSmartee Debt-To-Income Ratio calculator.

4 Types of Mortgage Loans

There are different types of mortgage loans, and some of them have different standards regarding what your DTI ratio needs to be.

1. Qualified mortgage

This type of loan has certain restrictions that protect the lender. These restrictions protect the borrower too in the sense that borrowers won't be able to take out a loan they can't afford. One restriction is that you must have a DTI ratio no higher than 43%.

In the subprime mortgage heyday, lenders would get creative with loan products so they could make a deal. They offered different types of loans that had a low initial mortgage payment to make the loans seem affordable. The problem with these creative loans was that once the initial low period ended, borrowers would often default, and then they'd lose their homes.

Here are some types of creative loans, none of which are allowed under a qualified mortgage:

  • Interest-only loans: borrowers would make only the interest payments for a certain time, while not paying down any of the principal.
  • Balloon payments: borrowers get to pay a lower monthly payment for a while, but they then have a huge payment at the end of the loan's term.
  • Mortgages for longer than 30 years
  • Negative amortization: borrowers pay the principal but not the interest for a certain time. With these loans, the principal could actually increase.

Qualified mortgages have more stable features than creative loans do. These features (or restrictions) help ensure borrowers will be successful in being able to afford the mortgage over time. Lenders will make sure you have the ability to pay back the loan by looking at your income, employment, assets, credit score, and debt load.

2. FHA mortgage

FHA home loans

FHA loans are insured by the government. People who can't qualify for a conventional loan (loans that aren't insured by the government) often can qualify for an FHA loan.

Your credit score can be as low as 580 to qualify, and you would need to make a down payment of only 3.5%. You can even qualify for an FHA loan with a credit score as low as 500 if you can put down 10%. There are extra fees associated with FHA loans, and you pay a mortgage insurance premium for as long as you have the loan. But it's a great way to get into a house, and it does not involve creative financing. Instead, there are DTI limits.

The FHA breaks the DTI limits into two categories: front-end and back-end. We've been, up to now, discussing only back-end DTI ratios.

Back-end ratios refer to all the debt you have. Front-end ratios are housing-related debt only.

The FHA limits for a back-end debt ratio are 43%, the same as with a qualified mortgage, but you also must meet a front-end debt ratio of 31%. That means your total debt can't be more than 43% of your income, and your housing-related debt (your PITI), can't be more than 31% of your income.

If your DTI ratios are higher than 31%/43%, you might still be able to qualify for an FHA loan, as FHA lenders can be flexible. Here are some circumstances that might work in your favor, even if you have a high DTI ratio:

  • Offer to put down a higher down payment than is required.
  • If you already had a mortgage loan that you successfully paid with higher payments than the loan you now want, let your FHA lender know. You might be approved since you've already proven your ability to pay.
  • Have a significant amount of money in savings, typically about three months worth of mortgage payments.
  • Have an excellent credit score.

3. VA home loan

U.S. department of veteran affairs

VA loans, like FHA loans, are insured by the government. This loan product is for members of the military, and its purpose is to make it easier for our military to buy a home.

There are certain advantages to VA loans, such as they don't require borrowers to make a down payment, there is no private mortgage insurance or mortgage insurance premium to be paid, and it's generally easier to qualify for a VA loan than it is to qualify for a conventional loan. However, lenders in the VA program do look at your DTI ratio, which needs to be 41% to qualify for a VA loan. But like the FHA loan, there are extenuating circumstances that lenders sometimes consider. This would depend on the lender.

There is another number the VA considers: residual income. This is income you have left over after you've paid your debts. The VA has a table for how much residual income you need, and this is broken down into region. For example, if you have a family of four, you would need a residual income of $1,025 if you live in the Northeast, $1,003 if you live in the Midwest or the South, and $1,117 if you live in the West. If your DTI ratio were higher than 41%, you would need a 20% higher residual income to qualify for a loan.

4. USDA loan

USDA home loan

USDA loans are part of the U.S. Department of Agriculture and are another type of loan insured by the government. These loans are for moderate- and low-income borrowers who live in rural areas. The DTI ratios needed to qualify for a USDA loan are 29%/41%, which means the front-end ratio needs to be 29%, and the back-end ratio needs to be 41% to qualify.

Summary

Lenders look at your DTI ratio as one factor in determining whether you are approved for a mortgage loan. However, DTI is only part of the picture. If your debt level puts you over the standard DTI ratio but you have proven that you always pay your bills on time (having an excellent credit score), can put down a larger-than-required amount for a down payment, have at least three months worth of mortgage payments in a savings account, and have a steady income, you could be approved for a mortgage even with a high DTI ratio.


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